CIMA BA3 Syllabus A. ACCOUNTING PRINCIPLES, CONCEPTS AND REGULATIONS - Accounting concepts - Notes 8 / 22
Underlying Assumptions
The Framework sets out two concepts which can be presumed when reading financial statements:
Accrual Basis
The effects of transactions and other events are recognised when they occur, rather than when cash or its equivalent is received or paid, and they are reported in the financial statements of the periods to which they relate.
Going Concern
The financial statements presume that an enterprise will continue in operation in the foreseeable future or, if that presumption is not valid, disclosure and a different basis of reporting are required.
Other Accounting Concepts
The business entity concept (separate entity)
In accounting, a business should always be treated separately from its owner(s).
Substance over form
Transactions need to be accounted for and presented in accordance with their substance and economic reality even if their legal form is different.
Fair presentation
The financial statements must "present fairly" the financial position, financial performance and cash flows of an entity.
Fair presentation requires the faithful representation of the effects of transactions, other events, and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework.
IAS 1, “Presentation of Financial Statements” states that:
1. compliance with IFRSs should be disclosed
2. All relevant IFRS must be followed if compliance with IFRSs is disclosedIn some rare circumstances, management may decide that compliance with a requirement of an IFRS would be misleading. Departure from the IFRS is therefore required to achieve a fair presentation.
Consistency
The same accounting principles should be used to prepare financial statements over a number of periods
IAS 1 states that for a fair presentation, the following is required:
selection and application of accounting policies
presentation of information in a manner which provides relevant, reliable, comparable and understandable information
additional disclosures when required
Historical Cost
Historical cost has been defined as the amount paid or fair value of the consideration given.
Advantages of Historical Cost Accounting
The cost is known and can be proved (e.g. against an invoice). It is therefore objective
It enhances comparability
It leads to stable pricing – using current market values would lead to volatility in asset values
Disadvantages of Historical Cost Accounting
Non-current asset values are unrealistic
Since non-current asset values are low, depreciation is low and does not fully reflect the value of the asset consumed during the accounting year
Lower costs, e.g. depreciation expense, would lead to higher profits.
There is a possibility that this may lead to higher taxation, wage demands and dividend expectation (based on overstated earnings per share).
The combination of these effects is that a company may overspend or over distribute its profits and not maintain its capital base.
Comparisons over time are unrealistic
Understatement of asset values tends to overstate gearing, and leads to a low asset per share value and can make the company vulnerable to a take over
Where assets, particularly land and buildings, are being used as security to raise finance, it is current value that lenders are interested in, not historical values
These disadvantages usually arise in times of rising prices. In fact, in times of rising prices, historical cost accounting tends to understate asset values and overstate profits.
Prudence
The Conceptual Framework views prudence as a component of neutrality, which is a characteristic of faithful representation.
Prudence is described as:
'the exercise of caution when making judgements under conditions of uncertainty. The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated.‘
As an accountant, it is important to exercise caution when making accounting estimates.